Plan sponsors invest significant resources to determine the optimal strategic allocation of plan assets across various style mandates and then select the best managers to implement those mandates. Staying true to those mandates, which are typically benchmarked to an appropriate index, is important in order to maintain the ongoing diversification of the plan assets.
Fortunately, active share analysis gives plan sponsors a very effective tool to evaluate and document manager style drift and/or manager conviction to their mandate over time. Active share, expressed as a percentage, measures the extent to which a portfolio’s holdings overlap with those of a benchmark. Portfolios with a high active share are taking significant active bets versus the benchmark holdings. Those with low active share are taking few active bets—in fact, an active share of 0.0% would indicate that the portfolio is identical to the benchmark index.
Comparing a portfolio against its primary benchmark, as well as other style indices, over different periods of time can shed light on how closely and consistently the portfolio hews to its mandate. Below are two examples of how this type of analysis can be used:
1. Portfolio Active Share vs. Multiple Indices: Style Conviction over Time
One would expect that a portfolio, when compared to a variety of indices, would exhibit the lowest active share against its primary benchmark. Thus, a small-cap growth portfolio should have a lower active share against the Russell 2000 Growth Index than, say, the Russell 2000 Value Index. Portfolios that consistently demonstrate the lowest active share versus their primary benchmark are likely managed through a disciplined investment philosophy and process, an important consideration when evaluating managers.
The graph below illustrates how a portfolio conforms to the style described by its primary benchmark, “<index 1>,” and other indices over time.
This portfolio’s primary benchmark index is denoted by the thick blue line. As you can see, this hasn’t been the one with the lowest active share in the past, but the portfolio is beginning to align with its primary benchmark as of the latest period. Is this due to style drift or are there other reasons why the portfolio has had trouble staying in alignment with its primary benchmark?
Perhaps the portfolio’s strategic mandate changed during the period covered by the chart, or reallocations of cash into or out of the portfolio temporarily disrupted the manager’s investment discipline. Both could explain the early periods of misalignment with the primary benchmark in the above chart. Structural changes to the composition of the benchmark index can also create misalignments, although these tend to be shorter-term anomalies and smooth out over time.
Of course, perhaps the portfolio simply has a history of style drift. No matter what the rationale in the example above, having access to this type of historical active share information allows plan sponsors to engage in a meaningful discussion with their managers about how exogenous factors affect their portfolio, the discipline of investment processes and commitment to style consistency.
2. Active Share vs. Style Indices: Consistency over Time
This chart illustrates another way to use active share/multiple indices analysis, one suggested in the original research by Profs. Martijn Cremers and Antti Petijisto—that active share could be used to track the style of a fund over time.
Based on a specified set of color-coded indices, the chart identifies the index with the lowest active share at the end of each time interval. The portfolio is determined to “belong” to the style represented by the index with the lowest active share. If the color remains the same across all intervals, it indicates the portfolio has been consistent in its style and/or investment approach.
As an example, let’s say we are measuring a small-cap growth manager whose primary benchmark is the Russell 2000 Growth Index. For the purposes of this analysis, you specify the following indices and color for the chart above:
- R2000 Growth; Small-Cap Growth - Pink
- R2000; Small-Cap - Green
- R2000 Value; Small-Cap Value - Gray
- Russell Mid-Cap; Mid-Cap - Blue
The first thing to note is that in no period did the portfolio have the lowest active share when compared to the Russell 2000 Value or the Mid-Cap Indices—thus, neither gray nor blue appears in the chart. That’s good news for this plan sponsor, since it provides evidence that the manager’s portfolio has not strayed from its cap or style mandate.
The second thing to note is the portfolio has had the lowest active share to the Russell 2000 Growth Index in all but two periods displayed in the chart. Clearly, the portfolio is most often in line with its primary benchmark and tends to stay true to its small-cap growth mandate.
What’s happening in the two periods when the portfolio had the lowest active share versus the Russell 2000 Index? Those intervals may be anomalies, or due to index reconstitution, or perhaps they signal an evolution in the manager’s investment approach.
While active share analysis may not provide all the answers to questions of style drift, it can provide the evidence necessary to validate a manager’s style consistency—or to stimulate discussion as to why they drift from their mandate.
This article is last in a three-part series about how plan sponsors can use active share to manage and monitor equity portfolios. See also, “Paying Active Fees for Passive Management?” and “Active Share Helps Plan Sponsors Fulfill Fiduciary Responsibilities.”
Thusith Mahanama, CEO, Assette, provider of client communications solutions headquartered in Boston
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.